Stock options can be a valuable perk for employees. Not only do they benefit workers, who stand to financially gain from them, but they also ensure participants are personally invested in the success of the company. If an employee stands to make money from the business’s continued success, that person is more motivated to do a good job. But issuing stock options can be a gamble if the employee doesn’t stick around, which is where restricted stock units come in.
What Are Stock Options?
By definition, stock options refer to stocks that are sold from one party to another without the obligation to buy or sell it by a specific time. An option can be bought or sold at any time prior to the expiration date, but there’s no obligation to do so. Employee stock options are only one kind of stock options.
When you accept stock options as part of an employment agreement, you’re essentially signing a contract to purchase a specific number of shares at a set price at a time period outlined in the agreement. The goal of stock options, in addition to attracting the best employees, is to give employees an incentive to improve the company’s performance, which benefits everyone. Originally, stock options were offered primarily to those at the top of a company, but startup culture has made it popular for employees at all levels.
What Is an RSU?
A restricted stock unit is a type of stock option. Instead of giving an employee shares and allowing him the freedom to buy and sell it at any time, RSUs are given with limits. RSUs have a vesting plan, which usually highlights certain milestones that must be reached before the funds can be distributed. Those milestones may be performance goals or years of service.
Although RSUs give an employee interest in a company’s stock, it has no value until the vesting terms have been reached. At the time in which they vest, the employee is given the shares, with a portion withheld to put toward income taxes. At that point, the employee can sell the shares if he chooses.
Differences in Settlement
One major difference between stock options and restricted stock units is what happens when the vesting period is over. With stock options, once that period ends, those options become common stock. The employee has the choice to either buy or sell that stock.
An RSU, on the other hand, is settled as outlined in the terms. The employee can ask that an employer defer settling the option for a short time frame after vesting, thus putting off paying income tax on it a little longer. However, in doing so, the employer has to make sure all tax laws are carefully followed.
Nonqualified Versus Incentive Stock Options
Within stock options, there are actually two different types. Nonqualified stock options can extend to numerous people that support an organization, including consultants and outside directors. NSOs are more of a perk offered to all employees as part of the recruiting process and receive no special tax treatment.
Incentive stock options, on the other hand, generally stay within the immediate staff, serving as an “incentive” for team members to boost performance. These are most often seen with CEOs, CFOs and other team leaders who are considered part of the executive team. Unlike NSOs, ISOs tend to receive preferential tax treatment since lawmakers tend to think these types of high-level incentives strengthen the overall economy.
Difference in Tax Treatment
At tax time, you’ll see a difference in the year at which you take your stock options versus the year you settle your RSU. With stock options, you’ll pay taxes if you choose to sell the shares. The taxes you’re charged will be paid at the going capital gains rate at the time. If your stock option is of the nonqualified variety, when you sell it, you’ll pay income taxes on it.
With RSUs, however, you’ll be taxed on the market value of the shares at the time you reached vesting status. For RSU tax, you’ll pay income tax on that value, and that tax will be withheld from the amount your employer pays you, rather than you having the burden of paying it at the time of filing. If your company gives you the stocks instead of you settling, and you hold those shares for more than a year, you could face capital gains tax.
Single Versus Double Trigger RSU
Taxes can get a little complicated with an RSU due to the fact that there are two types: single trigger and double trigger. A single-trigger RSU taxes you as it vests. That means with each vesting date, you’ll have taxes taken out based on the market value at the time of vesting. This will be taxed as ordinary income unless you hold the stock for a year or longer after vesting, at which point it becomes capital gains.
A double-trigger RSU, on the other hand, doesn’t trigger taxes until two things occur: it has vested, and the company files for an IPO. Double trigger only applies if you join a company and take an RSU before it has gone public, so in many cases, employees won’t have to worry about this. In this case, generally the tax will be due at the date the IPO is made.
The History of RSUs
Although RSUs have been around for a while, they originally were reserved for executive-level employees. But accounting scandals in the 2000s led businesses to seek out better ways to lure top talent other than stock options. At that point, more companies began offering RSUs as a job perk to employees at all levels.
As large corporations like Microsoft began switching from stock options to RSUs, the popularity of stock options dropped sharply. From 2003 to 2005, Fortune 1000 stock option issuance dropped by 40 percent, while the use of RSUs increased by about 41 percent during that time frame. Since then, RSUs have become much more standard, but some businesses offer employees the option of RSUs or stock options, leading them to weigh the differences.
RSU vs. Options Advantages
Stock options are great when used as an employee benefit. Startups and other small businesses can have difficulty competing with large corporations when it comes to perks, so many have relied on making new employees feel as though they’re part of leading a growing company by offering shares. At the executive level, stock options can provide the perfect incentive to work hard and improve a company’s performance.
It’s also important to consider stock option versus RSU tax treatment when considering the benefits. Making stock options the RSU variety means taxes will be taken out at the time the employee is vested. On the other hand, employees who hold unrestricted stock options have more flexibility when it comes to taxation since they choose to sell it or buy it.
Dangers of Relying on Options
Although stock options are a great job perk, they shouldn’t be your sole financial plan. It can be dangerous to rely only on shares in one company when preparing for your future. Even if you believe in your employer and the work they’re doing, if something happens along the way, you could stand to lose your entire investment.
As you sign up for stock options with your employer, also look into other investment options. Stock options are no replacement for a retirement savings account, so make sure you have something relatively low-risk in place to protect yourself. Build a diverse portfolio with companies that are in completely different industries. If you work for a tech firm, for instance, investing only in other tech firms won’t serve as a protection if the entire industry takes a nosedive.
RSUs vs. Stock Options Risk
There is a protection you’ll get with RSUs that doesn’t come with stock options. If your share prices drop to the point where they’re below the option price, your own options will lose their value. This means your “investment” won’t have any worth.
On the other hand, an RSU will hold its value to start to finish. If your company goes out of business, you’ll lose what you had in. But this eventuality is much less likely than a business’s stock losing money over the course of the years it takes to get vested.
401(k) Matches vs. Stock Options
When it comes to employer benefits, sometimes you have choices beyond RSU vs. options. If you’re in the middle of the job search process, stock options are one way to go, but don’t discredit the value of a solid retirement plan. At one time, these came in the form of pensions, but more employers today offer a 401(k) versus a pension.
Generally speaking, a 401(k) is a better route than stock options, especially if your employer promises a match. Matched contributions mean your employer puts money into your retirement account to equal the amount you’re contributing. This is, essentially, free money. If offered a choice, choose index funds that have low management fees for your 401(k).
What to Do With Proceeds
With an RSU, when you reach your vesting period, you’ll get a payout for the amount. This then puts you in a quandary. What do you do with the new money you have on hand? It actually provides the perfect opportunity to get started on building a strong financial future, provided you take the right steps.
Reinvesting any proceeds you’ve made from your stock options doesn’t mean you have to abandon your employer altogether. If you still work there, you may want to put some money back into shares in the business you’re helping build. The key is to keep your portfolio diverse even as you’re holding shares in your workplace.
It may help to seek out the assistance of a financial adviser if you’re interested in building a portfolio. Whether you should take a chance on some riskier investments while also putting money into low-risk options depends on your age and your current financial standing. Relatively safe retirement plans like IRAs may be a better option than putting your money into the stock market.
IPOs and Stock Options
One incident that may have you fastidiously researching where your stock options stand is when your business files for an IPO. You may have purchased stock options or RSUs at the time of hiring, then forgotten about them. But a company’s IPO can, in some instances, trigger a need to take action on your stock options.
When an IPO is taking place, your employer will likely give you a deadline at which time you’ll need to exercise your options. You don’t have to wait until the last day of that deadline, but you may want to. This will give you extra time to research what the tax repercussions will be and make the best decision for your own bank account.
Video of the Day
- Investopedia: Stock Option
- Forbes: Getting The Most Value From Your Employee Stock Options
- Investopedia: Restricted Stock Unit - RSU
- Wall Street Mojo: Stock Options vs RSU (Restricted Stock Units)
- KPM CPA: Awards of Restricted Stock Units Can Provide Tax Deferral Opportunity
- Charles Schwab & Co.: RSUs: Essential Facts
- CNBC: How to Avoid the Tax Traps of Restricted Stock Units
- Investopedia: Retirement Savings: 401(k) vs. Stocks
- Investopedia: The Benefits and Value of Stock Options